Tuesday, September 30, 2008

All the measures of fear, uncertainty and doubt have subsided, and the waves of selling that drove prices down yesterday are retreating. The sky hasn't fallen, even though Congress is taking a day or two off. Yesterday I should have remembered a favorite maxim: by the time the politicians figure out there is a crisis and pass laws to fix it, it's too late, probably unnecessary, and only tends to make things worse.

I'm also remembering that the eventual losses from subprime loans are indeed finite, and the bulk of them have been declared, absorbed, and written off. In round numbers (don't quote me on this), subprime loans totaled about $1.5 trillion. Even if you assume the absolute worst, that every single loan defaults and banks recover only half of the original loan value when properties are foreclosed and sold, the total losses can not be more than $750 billion. More realistically, the total losses can't be more than $500-600 billion, because obviously not every borrower will go bust and not every house will lose half of its value. I believe we've already seen the bulk of those losses realized by unfortunate banks, insurance companies, hedge funds, etc. Maybe there is another $100 billion or so that's waiting in the wings, but how could such a piddling amount bring the $15 trillion US economy to its knees?

Those who argue that the sky is going to fall if Congress doesn't act are betting that the losses will be far more than is possible from defaulted subprime loans. They worry about all the leverage in the system and the many trillions of swaps and other derivative contracts. But those things are just ways in which the system redistributes risk; they magnify risk for some and reduce it for others. As for total risk, it's a zero sum situation.